The Income Gap: Is the Distribution of Money Fair?

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In the mid to late 1800s there was an important debate in economics about how the price of goods and services is determined. On one side were the proponents of a labor theory of value, a view often attributed to Marx but the roots of this theory go back to at least Adam Smith and continue through David Ricardo and others. According to this theory all value is created by labor – capital itself is nothing but stored up or “embodied” labor – so that the price of a good can be determined through clever calculations that determine the quantity of the direct and indirect labor used to produce it.

This leads to a view of the world where class struggles between owners and workers are a prominent feature of the economic landscape. If one group of people does almost all of the work in society and thus creates almost all value, and other groups get a share of that output through the power that comes with ownership, e.g. through rental or interest income, without contributing much work themselves, then one class must be living off – exploiting – the other.

The other side of the debate, which provides a much better explanation for prices, presents a more harmonious view of economic relationships. Under the alternative theory, the value of a good or service is determined by its usefulness. It is the utility of a good rather than how much labor it takes to produce it that determines its price. Thus value becomes subjective – it is no longer an objective, measurable quantity such as the caloric exertion involved in the creation of the good or service – and this has important social implications.

When value is subjective, capitalists and landowners can contribute to the value of a good even if no physical labor is involved. J.B. Say of Say’s Law fame, for example, augmented the traditional factors of production – land, labor, and capital – with a 4th, the entrepreneur. He claimed that the sacrifice of consumption that must be endured in order to save the money needed to finance a new business venture was every bit as loathsome as physical labor, and hence deserved to be rewarded in the same way. Later writers would extend this notion and add factors such as risk and management – putting your savings at risk in a new business venture deserved compensation, as did management effort, and so on.

The result of this theory was the claim that all participants in the production process, laborers, landlords, and capitalists alike, receive an income equal to their “sacrifice.” Later developments modified this result to say that each person in society receives an income equal to their contribution to national output and the natural question that followed, one pointed directly at the Marxists and their class conflict, exploitation view of the world, was “what could be fairer than that?”

Economists do not have a way of judging fairness. Such judgments involve moral questions that are best left to society as a whole. But if we adopt the simple notion that every person has a right to a share of output equivalent to their contribution to it (net of costs such as taxes for the roads, bridges, schools and the like needed to support these activities), then a competitive economic system does produce a justifiable outcome, at least in theory.

But the theory, which relies critically upon the existence of perfect competition, requires a whole host of assumptions to support it. When these conditions are violated there is nothing that says the resulting outcome necessarily accords with the “every person gets what they deserve” properties of perfect competition.

Are the assumptions needed for perfect competition anywhere close to being satisfied in today’s world? I believe the answer is no. One piece of evidence is that the theory of pure competition tells us that workers’ wages ought to rise with changes in productivity – when they produce more each hour, they should get more. But in recent decades workers haven’t received increases in compensation anywhere near the increase in their contribution to national output. That share of income has gone somewhere else, and all signs point to the very top of the income distribution, the place where economic and political power is the greatest. And there’s no need to look much further than the financial industry with its too big to fail firms that dominate the markets they participate in for further evidence of how far we are from the perfect competition model in our textbooks.

Those who promote the free market system and oppose government intervention implicitly adopt the moral position that it is fair and equitable for people to keep what they produce. But when there are important deviations from the purely competitive markets needed to ensure this outcome, free market advocates should not object to the redistribution from an “ownership class” that appears to receive more than its contribution to the nation’s output to those who were not fully compensated for their hard work in producing the goods and services that we all enjoy.

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University of Oregon macroeconomist Mark Thoma writes primarily about monetary policy its effect on the economy. He has also worked on political business cycle models. Thoma blogs daily at Economist’s View.